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Excellent Bloomberg Article on the deficit...

WARNING: This requires math and arithmetic, which is essential to understanding the economy. There are a lot of people who don't use arithmetic when discussing the economy.

The Deficit: Not as Bad as They Want You to Think
By Evan Soltas Dec 26, 2012 4:57 PM ET

If those so-called deficit hawks would stop moralizing long enough to look at the data, they might find something surprising: That data almost entirely undermine their argument.

Yes, the long-run path of spending on federal health programs remains a serious and legitimate source of concern. But the numbers show that our current fiscal deficit is well within control -- as have been the deficits of the last five years.

The right way to evaluate the U.S.'s current fiscal condition is not to look at at its budget deficit, which fluctuates sharply due to economic conditions. Rather, it is to calculate the structural budget deficit, the difference between government spending and revenues when the economy is normal. (More technically, it is when the "output gap," the difference between actual and long-run potential economic output, is zero.)

For this post, I have calculated estimates of the current structural fiscal deficit from 1949 to 2012 with data from the Office of Management and Budget.These estimates come from breaking down the deficit into its components -- spending by individual program and revenues from each tax -- and computing their sensitivity to the output gap over time through linear regression. My estimates of the output gap come from the Congressional Budget Office.

For fiscal year 2012, the annual structural deficit was $325 billion, or 2.1 percent of GDP. (See the first graph accompanying this post.)

That is worse than no structural deficit at all. But it is hardly unsustainable. The U.S. economy is capable of growing at that pace over thelong run, which means that the ratio of debt to GDP, a key measure of sustainability, will be stable. The weak economy explains the remaining $1 trillion of the deficit, which amounts to 6.5 percent of GDP.

My calculations suggest that federal taxes would bring in revenue of 18.2 percent of GDP, and federal spending would amount to 20.3 percent ofGDP, given an average economy. That compares to current tax revenue of 15.9percent of GDP and spending at 24.5 percent of GDP. (See the second graph with this post.)

It is likely that these figures overstate the size of the structural deficit in 2012. The OMB projections I use in my analysis appear tohave significantly overestimated the amount of spending, and underestimated the amount of tax revenues, in the 2012 fiscal year. So it is possible that the structural deficit is closer to 1.5 percent of GDP.

These calculations are never more than approximations, but theygive a strong indication of when changes in the deficit are cyclical and when they are structural. For example, spending on unemployment insurance is highlycyclical, whereas spending on veterans' health and Social Security payments are mostly structural. Not all changes in spending and tax revenues are createdequal, in other words, and looking at the deficit on a program-by-program, tax-by-tax basis allows a much more accurate structural estimate. (Here are my data and calculations.)

All of these calculations are robust to different specifications -- that is, no matter what assumptions I made, I came up with approximately the same numbers. The figures presented in this post are averages of the different specifications tested.

Paul Krugman came up with similar back-of-the-napkin estimates in a recent column, "That Terrible Trillion." These detailed calculations confirm Krugman's observation. They are also a follow-up on a 2009 report from the CBO that used similar methods.

My figures, however, assign significantly more of the swings in revenues and spending from the Clinton administration onward to cyclical rather than structural factors. Income tax revenues, for example, have become more cyclically volatile as the burden has shifted in recent years toward high earners, whose incomes are less stable. Like mine, however, the CBO's analysis also attributes a large component of recent budget deficits to cyclical factors.

None of this is to say that the long-run budget picture is sustainable. In fact, it plainly is not, as the federal government faces a severe challenge of financing the large and growing cost of its health programs. But the U.S.'s budget problem is not as dire as the budget numbers would imply at first glance.

Fiscal policymakers need not think about fixing deficits in the short run. The cyclical deficit will take care of itself as the economy recovers. Instead, they should seek to contain long-run pressures on the structural budget deficit. The ideal solution would plot a path to reduce the structural deficit over a decade through increases in tax revenue and cuts to spending.